February 17, 2012 by Shawkat Hammoudeh
Morgan Stanley Capital International (MSCI) classifies the world’s stock markets into frontier, emerging and developed markets, depending on the depth and breadth of those markets. The Gulf Cooperation Council countries of Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates are classified as frontier markets. Many of these markets do not allow adequate direct ownership by foreign investors and lack proper payment-delivery systems. Therefore they do not qualify to be emerging markets. On the other hand, China’s Shanghai and Shenzhen’s A- and B-shares are classified as an emerging market. The Chinese market has the breadth of developed markets but lacks the depth. It has the world’s third market capitalization but does not allow short selling or buying and selling options and futures on individual stocks.
The Chinese market allows foreign ownership in the B-shares on both the Shanghai and Shenzhen markets. Both A- and B-share classes have equal rights. However, there are two restrictions on the B-shares: No individual investor can have more than 25 percent of the shares of one company, and foreign ownership cannot exceed 49 percent. The GCC can learn from this institutional feature of the Chinese markets. The GCC markets can have a modified shares classification similar to that of the Chinese shares classification. They may allow equal voting for both domestic and foreign investors but with phased-out foreign ownership over a specified period of time. The Chinese markets have a futures market based on the indices of both markets which should be considered by the GCC markets.
Our research finds herding in both the GCC and Chinese markets but more so in China’s B-shares than A-shares. Maybe the difference in the degree of herding between the A-shares and B-shares explains why those who invest in them suppress their beliefs and public and private information to follow the actions of others. This means herding entails “doing as the Romans do.” The foreign investors in the B-shares posses lower information quality than the more informed domestic investors who acquire better information through the media, personal contacts and consumption of the products. The implication of varying herding strengths between the A-shares and B-shares suggest that investors in the GCC markets are not well informed and their markets lack proper disclosure and transparency.
Herding usually happens at times of stress in the financial markets. The dispersions between stocks decline as investors do likewise. Here our research finds Chinese and GCC markets to herd during extreme or crash volatility but not during the low-volatility regime. Our research finds Chinese and GCC market structures to have three volatility regimes instead of two, which characterize the developed markets. The three volatility regimes are low volatility, high volatility and extreme, or crash, volatility. Developed markets usually undergo the low- and high-volatility regimes. My co-author and I believe that the third regime in Chinese and GCC markets has something to do with the depth, not the breadth, of the market. As indicated earlier, China has the third global market capitalization but still has a crash regime. Therefore the development of those markets is crucial for avoiding the crash regime.
Although these frontier and emerging markets have three volatility regimes, still the Chinese markets are safer than the GCC markets when it comes to cycling between the three regimes. The Chinese markets recycle from the low-volatility to the high-volatility to the crash regime. The cycling from low volatility to high volatility before the crash signals to investors that the worst is coming and they should get ready. However, the cycling in the GCC goes through the low volatility to crash to high volatility. This makes the GCC markets much more dangerous than the Chinese market.
What should investors do if they want to invest in the dangerous GCC markets? In order to hedge against an abrupt jump from the low-volatility regime to the crash, investors in those markets should balance a good portion of their stocks by investing in low-volatility (beta) stocks such as high dividend-paying stocks. Policy makers in those markets should increase the depth of their markets by developing financial derivatives that hedge against crashes. They may allow the issuance of crash options similar to the hurricane options in the United States. They should follow the Chinese model and introduce B-shares but with 49-percent restricted rights of ownerships. The secret of success of two stock classifications is the number of listed companies.
This comparison shows that frontier and emerging markets can be very different, and this difference should be recognized by both investors and policymakers in those markets.
Shawkat Hammoudeh is a professor of economics. He can be reached at [email protected]